A Picture's Worth A Thousand Words

Quick follow up on our Earnings Revisions post from yesterday. In that post, we explained that:

Consensus
earnings estimates for 2011 and 2012 are still greater than $95 and
$108, respectively, at the same time that GDP estimates are plummeting
(although still don’t face the harsh economic reality). To put these
figures into perspective, analysts were forecasting a near 20% decline
in earnings at the market’s trough. Today, expectations are for 22%
growth in the year ahead.

We show an example of this optimism
below. Cummins is a global leader in the design, manufacturing and
distribution of engines and related technology. The company’s engines
are found in a wide range of vehicles and equipment from emergency
vehicles to 18-wheelers, berry pickers to 360-ton mining haul trucks.
Management has done a tremendous job managing through the crisis. Costs
have been cut relentlessly, resulting in a leaner organization with
greater operating leverage. The balance sheet is rock solid. Not to
mention its image as a ‘safe’ play on the secular growth of emerging
market infrastructure development. It’s no wonder the street is in love
with the stock.

We have a difficult time arguing any of
the points above. Our concern is that the bar is set awfully high just
as we stare right into a cyclical slowdown at best and more likely,
something much more problematic. Note the company’s historic EBIT
margins below. Margins increased from 1.4% at the start of the decade
to a peak of 9.4% as the global economy marched straight up through 2006
on the back of the Chinese growth engine fueled by a credit-obsessed
American consumer. Then . . . something changed. And something changed
quite quickly. As economic growth screeched to a halt in 2008, margins
followed, moving in a straight line back to 1.7% in Q3-09. But with ‘a
little’ help from the greatest monetary and fiscal stimulus in economic
history, orders reappeared and a stream-lined Cummins surprised
analysts quarter after quarter, in route to a magical V-Shaped Recovery.

So what’s next? In classic fashion,
consensus has basically straight-lined that v-shaped recovery over the
next few years, as shown by the last piece of the chart highlighted in
red and representing consensus estimates through 2011. Wall Street
bulls – of which there are plenty, as none of the analysts covering the
stock are brave enough to rate it less than ‘hold’ – are now projecting
that the company’s margins reach record highs above 11% over the next
eighteen months. Such levels would be nearly 200 basis points above the
prior peak reached at the height of the credit-induced global growth
bubble. Possible? Sure. Likely? Eh. Not to mention that these
record margins on record sales would be achieved in a global economy in
the grips of an extended deleveraging process with much of the developed
world entering recession or battling depression. We can’t help but
wonder, who’s buying all this shit?

Disclosure: At the time of
publication, the author did not hold a position in Cummins, although
positions may change at any time.